Blockchains - Bitcoin
Overview
Blockchain is just another word for a ledger, or a database, or an accounting systems. They are special because they can store information in the open, within a hostile environment, but still in a trustworthy manner.
Bitcoin and its derivatives are called a blockchain because of how they store information. Transactions are grouped together into blocks that are linked together like a chain. The chain is what gives the system its strength: once a block is linked to the chain, it can no longer be changed.
A transaction is the smallest unit of information in a blockchain. A transaction is a request to send some amount of tokens from one user to another. A transaction can also be a request to store a piece of data onto the permanent record.
Anyone can send a transaction to be included in a blockchain. Transactions are sent to any of the nodes (servers) of the network. Transactions are accepted by every node into a temporary pool. After a period of time, a selection of the transactions are sealed together as a group and written into the permanent memory of the network. This group is called a block.
Blocks are necessary because the sealing action requires a significant amount of effort. It would slow things down significantly if every transaction were sealed individually. Each block is linked to the previous, one after another, in one long unbroken chain. A blockchain.
The blockchain has some unique properties. No one is able to make any changes to the chain, once it has been committed. Because they are cryptographically linked, changing even a single bit would disrupted the link and be detectible. The chain also guarantees that the ordering of transactions remains in tact. No one is able to grant themselves free tokens, or spend their tokens in two places at one time. This consistency satisfies our sense of fairness, which makes us willing to use it as an accounting system for value saving and transfer.
Some properties of blockchains:
- Immutable. A transaction can never be altered or erased once it happens. This allows you to see the complete history of an asset.
- Distributed: Transactions on the blockchain is stored by, and updates are broadcasted to, everyone.
- Decentralized: Communal consensus, rather than one party’s decision, dictates who gets to access or update the blockchain. Smart Contracts: Smart contracts are coded agreements. Once the predetermined conditions of the contract are met, the transaction is automatically completed and recorded on the blockchain, and the contract is immutable.
A visualization of a blockchain:
Consensus
Consensus is the process whereby nodes that don’t know each other can come into agreement regarding the validity and ordering of transactions. Decentralized consensus is difficult because it has to work even when there are some number of hostile actors who are deliberately trying to game the system (even at their own cost). In the case of most blockchains, as long as >50% of the actors are rational actors, who play by the rules, the system will function properly.
How do blockchains ensure they retain a majority of good actors?
There is no guarantee, but there ways to encourage success. Incentives are constructed in such a way that playing by the rules will yield a greater result than breaking the rules. An actor who assaults the system may be charged a significant fee taken from their bonded collateral. Ultimately, an actor who damages the network permanently will end up with a network that is not worth anything. These kinds of game-theoretic incentives have worked so far. Although there have been hacks and other minor exploits, the systems have proven to be stable and trustworthy. The hacks and exploits will reduce in time as these systems mature.
How does consensus work?
Bitcoin consensus innovation is called Proof of Work. Nodes (also called miners) in the network compete to solve cryptographic problems in order to earn the right to add a new block onto the blockchain. The fastest miner adds the newest block to the blockchain and is awarded with tokens. This practice requires immense processing power, meant to discourage attackers. As a payment for that work, the node receives the “block reward” (amount of new tokens minted out of thin air) as well as the transaction fees that are associated with the transactions in the block.
In Bitcoin’s case, this block reward also served as its initial token distribution mechanism. Bitcoin started with 0 bitcoins, then after each block was mined, a new 50 bitcoins were created. These tokens were worth nothing in a beginning but have quickly gained value. The rate of issuance is slowing down and will eventually stop. This has produced a stable system with a very small inflation rate that will eventually go to zero.
Ethereum has recently transitions to a consensus algorithm called proof of stake. Users “stake” or lock-up tokens to earn the right to become a block-producer of the blockchain. Users are chosen to become block-producer pseudo-randomly, depending on a set of factors (size of stake, age of stake). Users that are chosen are responsible for checking if the transactions in the block are valid, signing the block, and adding it to the blockchain. The stake works as a financial motivator for users not to validate or create fraudulent transactions.
There are many other variants on Proof of Work and Proof of Stake, each of which is tuned for a specific purpose. We will cover some of those in later sections.
How does one get blockchain tokens now?
Earning block rewards by participating in consensus is no longer feasible for average users. It requires a significant investment in capital for hardware or stake. Instead, users will have to buy tokens from someone else who is willing to sell. In the early days this meant going on a message board and advertising to meet someone local. Nowadays there are established exchanges that provide convenient on-ramps into cryptocurrencies. Here are some of the larger ones:
There have been a few exchanges that have collapsed over the years, like Mt. Gox and FTX. Some therefore recommend to store ones currencies outside of the exchanges. Storage and security of digital currencies remains one of the most challenging and perilous aspects of this space. There are no great solutions, only tradeoffs. How wallets work to store currencies will be discussed in a later section. But it is an evolving space, and the user experience and security guarantees are slowly but steadily making forward progress. Some rightly call this the new “wild west”.
How much is a cryptocurrency worth?
The glib answer is: whatever someone is willing to pay. In order to answer this question, many services have arisen to provide data and statistics about various networks.
There are marketplace data aggregators like Coinmarketcap and CoinGecko. All aggregators draw from differing sets of resources, and have their own biases. Best practice is triangulate between numerous sources. These aggregators will typical list:
- exchanges that trade a given currency
- daily trading volumes
- moving averages
- circulating supply figures and other network-specific values
One of the most popular ways to compare networks is by the “Market Cap”. This is the total value of the network if you take the current token price and multiply it by the circulating supply. Circulating supply is the number of tokens that are actually available to be traded, but it is a number that can be manipulated to create the perception of a much higher market cap. For this reason, market cap should be taken in consideration with many other factors when comparing networks. Other factors like trade volume can also be manipulated, so the same caution also applies. Historical value is generally very accurate and will always paint an interesting story of the history of the network. Because of the open nature of these networks, there is so much information to consider, but it requires a measure of caution and balance to approach.